You read Baumol et. al's "Good Capitalism, Bad Capitalism," and you come away with the argument that the best mix is to have big go-to-market firms surrounded by a sea of small, innovative high-tech firms that feed the beasts. The authors claimed that America was basically there, in terms of that evolution, having added the high-tech small firms with the IT revolution energizing our innovation base in a number of industries. Their addition evolved our economy past the big-firm era that marked the post-WWII decades through the difficult 1970s. The authors also argued that big-firm China was trying to make a similar evolution happen and was succeeding somewhat.

Now with the Great Recession, we get two counter-arguments coming to the fore: 1) globalization is slowly robbing America of its industrial base through off-shoring of manufacturing and losing the proximity between innovation and manufacturing is making us less competitive; and 2) China's increasing reliance on/championing of national flagship companies signals a retreat from further marketization.

My sense is always that linear projections usually fail, so waxing and waning is the norm. You go too fast down one path, so you pull your foot off the pedal for a period. I think some American companies in some sectors are recognizing the need to more closely tie innovation with manufacturing. But in others, like automotive, you don't have a whole lot of choice given the market expansion going on in Asia and Latin America.

In general, I'm a big believer in IBM CEO Sam Palmisano's notion of a globally-integrated enterprise that sources local, R&Ds local, hires local, manufactures local and sells local--just all over the world. It's the truly globalized or truly distributed version of the old multinational. I think companies that do that will fare best over the long haul, understanding that, as countries "rise," they're naturally going to want to carve out space in their expanding domestic market for national flagship companies. To me, this is China's path right now, along with a firm desire to lock-in access to raw materials around the world through their state-run extractive industries and farm land leasing/purchases. I think that mindset is a bit 20th century (supply risk oriented versus price risk oriented), but there you have it when a single-party state remains in power.

Now how China seeks to extend its evolution toward that big firm/small firm mix is to force foreign companies who seek entry into its expanding domestic market to turn over their technologies in joint ventures, something that's naturally going to create a lot of friction.

Less friction filled is what this Israeli private-equity firm is doing. Infinity Group is simply treating China like one giant big firm to which new technologies can be sold, with it playing matchmaker. The process reminds some of when Silicon Valley did the same for Taiwan way back when. Like Taiwan, China wants--nay, NEEDS--to move up the food chain rapidly in order to bring similar development to its better-than-a-half-billion interior rural pool that it has to-date achieved with the urbanized coastal provinces. Then there's China's demographic clock ticking, reflected in the long-term loss of 100m workers by 2050 and the piling up of 400m-plus elders by then.

To me, this is a next, natural phase for globalization, with smart small countries becoming more Israel-like and big, labor-filled developing countries emulating China's strategy, which, quite frankly, isn't unique whatsoever and really is just an updating of what Japan did (the Michael Pettis argument). If China were to achieve the same per capita GDP growth that Japan did, it could grow rapidly for another quarter century, says Martin Wolf, but . . .

The most interestingly pessimistic view comes from Michael Pettis of Peking University’s Guanghua School of Management. The characteristic of Chinese growth is that it is “unbalanced”, as Mr Wen notes: it is highly dependent on investment as a source of demand and driver of supply (see charts). It is, in a sense, the most “capitalist” economy ever.

Thus, between 1997 and 2009, gross investment rose from 32 per cent to 46 per cent of GDP, while household consumption fell from 45 per cent of GDP to a mere 36 per cent. This must be the lowest share of consumption in any significant economy ever. In a country with hundreds of millions of poor people, it is even shocking. Meanwhile, the rising investment rate has been the main driver of growth. In the early 2000s, “total factor productivity” – increases in output per unit of input – were also important. But the contribution of higher efficiency has been waning.

This, Prof Pettis argues, is a “souped-up version” of the Asian development model we saw in Japan and South Korea in earlier decades. The characteristics of this production-oriented approach are:

This has been an extraordinarily successful development model, but, notes Prof Pettis, it eventually runs into the constraints of “massive over-investment and misallocated capital”. He continues: “In every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies.” Moreover, China’s scale will shift the price of imports, particularly raw materials, against it, so accelerating the decline in profits.

In China, a rising rate of investment is needed to maintain a given rate of economic growth. At some point, investment will stop rising and growth will slow. China will then face the Japanese challenge: how to sustain demand as the required rate of investment collapses. If, for example, the gross investment needed to sustain a 10 per cent rate of growth is 50 per cent of GDP, then the rate of investment required to sustain 6 per cent growth might be just 30 per cent of GDP. With its massive dependence on investment as a source of demand, any decline in expected growth threatens a huge recession.

One answer would be another government-driven investment surge, however low the returns. The more attractive answer is faster growth of consumption. There is evidence of that during the past two years. But, as Prof Pettis notes, for consumption to grow consistently faster than GDP, household disposable income must also do so. Yet if this is to happen, income must be shifted from the corporate sector. That implies a squeeze on profits, through higher interest rates, higher real wages or a higher exchange rate. But that increases the risk of an investment collapse, with dire consequences for demand. As Prof Pettis argues, in China “growth is high ... because consumption is low”. Rebalancing the economy towards household consumption could undermine the ability to sustain growth itself. If so, China is on an investment treadmill.

Old story: there ain't no such thing as a free lunch. How China has grown makes it harder--with each passing year--to get off the investment treadmill. But that investment level, and the requirements of a trade surplus to feed it, creates it own negative feedback look, which China is just beginning to encounter. Can it run a huge trade imbalance with the developing world like it did with the West, using renminbi this time around? Pretty tall order considering its resource draw. Pettis's point isn't that China can't rebalance, just that it won't be a smooth journey.

But I can't help thinking that the work of Infinity Group is a big plus on this score: helping move China up for the production/labor wage chain by outsourcing the start-up function to a certain extent while it slowly builds that capacity at home. Naturally, if you're already a big firm and have amassed a lot of IP, you don't want to hand it over to China as price of admission, but if you're a start-up high-tech firm who needs a go-to-market partner, I can see you being indifferent on the nationality, meaning I think we'll see this become a significant trend in the global economy. Like Baumol et. al's preferred model, I think we'll see something similar in terms of small and large states. In a globalized world, tech firms in small states have no choice but to go global because the domestic market is so small (why Israel is such a high-tech incubator).

On that basis, I become even more convinced that the "clash of civilizations" will end up being a big nothing in retrospect, meaning merely a fraidy-cat capture of when globalization starting truly opening up previously-closed civilizations, triggering a totally natural uptick in cultural friction. But you look at an Israel making this happen with China and you say to yourself, in a clash-of-civilization world, this shouldn't work--yes? And yet it does, because Israel needs to do this and China needs to do this and that economic logic surmounts all.

Ah, U.N. Week — that time of year when Fox News sounds the alarm bells and The National Review starts making musical-theater references to impending speeches from Dictators with an Important Audience. And when the rest of us realize that Thursday's session with Iranian president Mahmoud Ahmadinejad will be quite the opposite: another round of comic relief sure to sabotage his own attempts to be taken seriously, followed by another round of (mostly) effective sanctions. The Obama administration already rolled one eye on Monday by refusing a detainee swap, so let's see just how far one man's stubbornness can be leveraged, shall we?

We're seeing this same story again and again over recent months: Israel is internally conflicted on how to make peace with Palestine in general and clearly has plenty of reason to resist any accommodation with Hamas in Gaza, and yet, a viable state and partner continues to emerge in the West Bank:

Rather than cursing the Israeli occupation, Palestinian Prime Minister Salam Fayyad, a former World Bank executive, has shifted the focus to building up the Palestinian state. Fayyad's government has improved security -- as Israeli army generals have acknowledged -- and the rule of law while also introducing far-reaching reforms in education, health and the economy. In its annual report on assistance to the Palestinian people, the U.N. Conference on Trade and Development estimates that gross domestic product in the occupied territories rose 6.8 percent in 2009. The recently unveiled second-year phase of this plan is titled "home stretch to freedom."

Palestinians have launched a public relations campaign, "I am a partner," aimed at the Israeli public. Featuring key Palestinian negotiators, it seeks to debunk the myth that there are no peace partners on the Palestinian side.

Geographically split states just don't work--outside of federated, networked America, that is. At some point, it just seems to make sense that Israel will cut some deal with the WB and reduce its Palestinian problem to just Gaza. The West Bank, by most accounts, is doing everything possible to make this an inevitability through internal development that'll need just some reasonable accommodation from Israel to make it far more robust.

So the question becomes, What does it take for Israel to split that difference for good? Forget the big outline. Just tell me how this thing works in the WB.

If America could be magically granted its ideal Muslim strategic partner, what would we ask for? Would we want a country that fell in line with every U.S. foreign policy stance? Not if the regime was to have any credibility with the Islamic world. No, ideally, the government would be just Islamist enough to be seen as preserving the nation's religious and cultural identity, even as it aggressively modernized its society and connected its economy to the larger world. It would have an activist foreign policy that emphasized diplomacy, multilateralism and regional stability, while also maintaining sufficient independence from America to demonstrate that it was not Washington's proxy, but rather a confident great power navigating the currents of history. In sum, it would serve as an example to its co-religionists of how a Muslim state can progressively improve itself amid globalization's deepening embrace -- while remaining a Muslim state.

as far as relevant history is concerned, forget about the Osirak strike in 1982 and instead think of 1956 and how the US opposed Israel’s efforts with France and the UK to humiliate Nasser, whom Stephens compares to Ahmadinejad today.

Stephen now places his faint hopes in an Obama Administration reconsidering the utility of military strikes—two plus years later, which makes no sense at all. If it was a gamble for Israel in the spring of 2008, how can it be any better of a gamble after Iran has had two and a half years to improve its countering preparations?

When even Stephens is reduced to such hope-mongering, you begin to get the sense that the world is learning to accept what was always inevitable.

This week, Israelsuccessfully conducted a test of a new mobile missile-defense system designed to shield Israeli towns from small rockets launched from the Gaza Strip. When the "Iron Dome" system is fully deployed in the next year, about half the cost -- $205 million -- will be borne by U.S. taxpayers under a plan advanced by the Obama administration and broadly supported in Congress.

While public attention has focused on the fierce diplomatic disputes between Israel and the United States over settlement expansion in Palestinian territories, security and military ties between the two nations have grown ever closer during the Obama administration.

As well it should. You don't ask friends to do difficult things (or accept difficult realities) without incentivizing them.

As always, I like my missile defense close in, covering those whom MAD cannot address except by extension (always mistrusted).

To me, this sort of stuff is exactly how we handle Iran's inevitable achievement of nuclear weapons, which isn't about achieving anything militarily, because nothing can be militarily achieved in this manner. Instead, it's about other subjects, where logically we can and should give Iran just enough rope to hang itself on the question of regime legitimacy--or the popular lack thereof.

In short, you deprive them of the enemy, which is how you Gorbachev their Brezhnevian carcass.

SINCE Israel’s deadly raid on the Turkish ship Mavi Marmara last month, it’s been assumed that Iran would be the major beneficiary of the wave of global anti-Israeli sentiment. But things seem to be playing out much differently: Iran paradoxically stands to lose much influence as Turkey assumes a surprising new role as the modern, democratic and internationally respected nation willing to take on Israel and oppose America.

While many Americans may feel betrayed by the behavior of their longtime allies in Ankara, Washington actually stands to gain indirectly if a newly muscular Turkey can adopt a leadership role in the Sunni Arab world, which has been eagerly looking for a better advocate of its causes than Shiite, authoritarian Iran or the inept and flaccid Arab regimes of the Persian Gulf.

Turkey’s Islamist government has distilled every last bit of political benefit from the flotilla crisis, domestically and internationally. And if the Gaza blockade is abandoned or loosened, it will be easily portrayed as a victory for Turkish engagement on behalf of the Palestinians.

Bottom line: this is all about Turkey's countering of Iranian influence, and just like Iran uses Israel as a whipping boy, now it's Ankara's turn, the difference being that when Tehran does it, it hurts US interests and when Ankara does it, it actually serves US interests--given Netanyahu's intransigence on all things Palestinian.

Turkey has a strong hand here. Many leading Arab intellectuals have fretted over being caught between Iran’s revolutionary Shiism and Saudi Arabia’s austere and politically ineffectual Wahhabism. They now hope that a more liberal and enlightened Turkish Sunni Islam — reminiscent of past Ottoman glory — can lead the Arab world out of its mire.

You can get a sense of just how attractive Turkey’s leadership is among the Arab masses by reading the flood of recent negative articles about Ankara in the government-owned newspapers of the Arab states. This coverage impugns Mr. Erdogan’s motives, claiming he is latching on to the Palestinian issue because he is weak domestically, and dismisses Turkey’s ability to bring leadership to this quintessential “Arab cause.” They reek of panic over a new rival.

I keep telling you, Turkey is moving big-time and in ways that benefit the region and US foreign policy interests.

Turkey's like the fourth-year player who's finally coming into his own on the roster. Yes, a big ego and a bit to handle, but how not to welcome this infusion of talent?

What drew me to this Economist story was the fears expressed within by those Israelis who believe Israel is losing its democracy in its increasingly lethal efforts to retain its national identity.

The key bit:

“For two generations we’ve denied the people across the green line their democratic rights,” says Professor Mordechai Kremnitzer, an academic lawyer and vice-president of the Israel Democracy Institute, a think tank. “That must impact on our society’s democratic ethos. Those who are ashamed find rationalizations: ‘We have no choice,’ they say. Or they cite ‘security considerations’ or explain the ‘uniqueness’ of our conflict with the Arabs. But many others are not even ashamed . . . ”

For Professor Kremnitzer, there is a danger not just that the Arab minority in Israel proper may be delegitimized but that the same fate could await critics of the government’s policy and especially of the Jewish settlements in the occupied areas.

He links this “ugly trend” to what he calls “a McCarthyite campaign against civil society”.

The Times (London) has a story that's popping up everywhere now. I got it via Michael Smith.

The supposition has always been there: the Saudis turn a blind eye toward Israel flying over its airspace (and perhaps even refueling on the ground at some makeshift landing site) in order to attack Iran's nuclear sites.

So now The Times reports:

Saudi Arabia has conducted tests to stand down its air defences to enable Israeli jets to make a bombing raid on Iran’s nuclear facilities, The Times can reveal.

In the week that the UN Security Council imposed a new round of sanctions on Tehran, defence sources in the Gulf say that Riyadh has agreed to allow Israel to use a narrow corridor of its airspace in the north of the country to shorten the distance for a bombing run on Iran.

To ensure the Israeli bombers pass unmolested, Riyadh has carried out tests to make certain its own jets are not scrambled and missile defence systems not activated. Once the Israelis are through, the kingdom’s air defences will return to full alert.

“The Saudis have given their permission for the Israelis to pass over and they will look the other way,” said a US defence source in the area. “They have already done tests to make sure their own jets aren’t scrambled and no one gets shot down. This has all been done with the agreement of the [US] State Department.”

No matter how Israel goes about it, we'll be complicit, and that's okay. While it will not get us the outcome we seek, beyond temporary delay, it signals our seriousness and our ability/willingness to strike. Ditto for the Saudis.

I'm against the US mounting a big-time effort, but I don't have any problem with Israel getting their limited-strike stuff off their chest. Israel wants the sensation of acting, and it dreams of a new president in the US come 2013 who would approach the problem differently, so this is a time-buying exercise like all the rest. Again, it won't accomplish much, but it does start the signaling process to come, when Iran does get its nukes.

Some tough-love advice from The Economist to Israel: the Gaza blockade makes you weaker and strengthens Hamas's ability to keep a firm grip on power in Gaza.

As usual, a strategy of disconnecting your enemy from the outside world empowers those ruling elements who prefer a firm grip over the masses to their individual empowerment.

More prosaically, the blockade has failed in all of its goals: the Israeli solder taken hostage is still a hostage, weapons galore still make their way into Gaza via tunnels, Israel is becoming more isolated diplomatically while Hamas is winning sympathy and still overshadowing the far more quiet and more competent West Bank Palestinian leadership. In short, all trends are heading south.

Obama is under fire here for "ruining" the relationship, but it's hard to see how he's guilty of anything more than simply realizing Netanyahu is no friend of the US and has no intention to pursue peace. So Obama cuts his losses and the relationship suffers. To me, that's a sensible choice given all he has on his plate regionally. And if that logic pushes Israel to bomb Iran, then so be it, because that'll just be another regional dynamic that he cannot control--especially when the Saudis collude to make it possible.

All of this is presented as tragedy, because Israel is the best thing about the Middle East in just about every other way. It is a connectivity hub in all relevant forms. It is, putting aside the Palestinian questions, the most admirable nation-state in the region--by far.

Where to go? Obama is encouraged to get Hamas back to the negotiating table. I see that as a useless proposition.

Given the losing hand it holds right now, I can foresee Israel making the logical leap to pounding Iran. Not much to lose and better dynamics to trigger. And I say this believing quite deeply that most of Israel's leadership knows they are heading--unavoidably--to a nuclear standoff with Iran that will soon be joined by others.

Given the situation Israel finds itself in now, I would say that migrating events down that path and establishing its tough profile on that subject would make a lot of sense.

Nice Friedman argument that we're missing the actual advances in Palestinian governance in the West Bank.

Key second half:

You see, there are two models of Arab governance. The old Nasserite model, which Hamas still practices, where leaders say: “Judge me by how I resist Israel or America.” And: “First we get a state, then we build the institutions.” The new model, pioneered in the West Bank by Abbas and Fayyad is: “Judge me by how I perform — how I generate investment and employment, deliver services and pick up the garbage. First we build transparent and effective political and security institutions. Then we declare a state. That is what the Zionists did, and it sure worked for them.”

The most important thing going on in this conflict today is that since 2007 the Palestinian Authority, Jordan and the U.S. have partnered to train a whole new West Bank Palestinian security force in policing, administration and even human rights. The program is advised by U.S. Lt. Gen. Keith Dayton — one of the unsung good guys. The Israeli Army has become impressed enough by the performance of the new Palestinian National Security Force, or N.S.F., under Abbas and Fayyad that those forces are now largely responsible for law and order in all the major West Bank towns, triggering an explosion of Palestinian building, investment and commerce in those areas.

Here are highlights: the Jordanians have trained and the Palestinian Authority deployed and equipped five N.S.F. battalions and one Presidential Guard unit, some 3,100 men. Plus, 65 Palestinian first-responders have been trained and are being equipped with emergency gear. A Palestinian National Training Center, with classrooms and dorms, is nearing completion in Jericho so the Palestinians themselves can take over the training. The Palestinian Authority is building a 750-man N.S.F. camp to garrison the new N.S.F. troops — including barracks, gym and parade ground — near Jenin. At the same time, the Palestinian security headquarters are all being rebuilt in every major Palestinian town, starting in Hebron. An eight-week senior leadership training course in Jericho — bringing together the Palestinian police, the N.S.F. and Presidential Guards — has graduated 280 people, including 20 women.

A course for captains and below in how to handle everything from crowd control to elections has also begun. The reinvigorated Palestinian Ministry of Interior is leading the Palestinian security sector transformation, and the Canadians are helping to set up Joint Operations Centers across the West Bank so all Palestinian security services can coordinate via video conferencing. The Canadians are also helping the Palestinians to build a logistics center. Parallel with all this, Prime Minister Bibi Netanyahu has reduced Israel’s manned checkpoints in the West Bank from 42 to 12.

This won’t be politically sustainable for Abbas and Fayyad, though, unless Israel begins to turn full authority over to the Palestinians for their major cities — so-called area A — in the West Bank. Palestinians have to see their new security services as building their state, not cushioning Israel’s occupation. There could be a moment of truth here for Israel soon, but at least it will be based on something real.

In sum, this dynamic — Palestinians building real institutions from the ground up and getting Israel to cede to them real authority — is the ballgame. Make it work across the West Bank and find a way to transfer it to Gaza (how about reopening the Israel-Gaza border and letting the new Palestinian N.S.F. control the passages to Israel?) and a two-state solution is possible. Let it fail, and we’ll have endless conflict. Everything else is just a sideshow.

A nice refocusing of strategic attention.

Is it enough of an argument to prevent Israel from taking its swipe against Iran over the nuke program? Only way we get definitive evidence is when the bombs start falling.

Per my post in Esquire’s The Politics Blog, Turkey seems to be moving with all premeditated speed to neck down its ties with Israel—all the better for the nuclear moves down the road. This is classic “chosen trauma,” in that it’s a BIG DEAL because it suits Ankara’s strategy to make it so.

Meanwhile, Israelis seem, as usual, to be of many minds on the subject. Few like the blockade but most see it as defensible, given Hamas’ behavior since taking power. Everybody seems to think the raid was poorly conducted, but likewise that Turkey set them up, so botched or not, Ankara wanted its bloody shirt.

As for the actual events, everybody sees what they want to remember, says the FT piece. Israelis see their forces under clear attack (please, no professional soldiers kill 9 people in such an operation unless they feel like they’ve got no choice regarding survival) and don’t much care about the cost borne by the instigators of the provocation. The West only sees its martyrs, thus a natural feeling of solidarity with ordinary Palestinians that most definitely benefits the criminally cynical—and by my measure inept—Hamas government.

To date, outside great powers have done nothing to alter this dynamic, meaning the upshot of the blood events is that Turkey executed—pun intended—the concluding act in their comprehensive de-alignment with Tel Aviv—nothing more and nothing less.

If the notion is, give the guy a fish and you feed him for a day, but teach him to fish and he eats everyday, then I detect a distinct desire on Israel's part to make sure Gazans learn how to do nothing for themselves.

Hard not to argue that these are essentially prison conditions, designed to punish more than allow economic rehabilitation.

Three German-built Israeli submarines equipped with nuclear cruise missiles are to be deployed in the Gulf near the Iranian coastline.

The first has been sent in response to Israeli fears that ballistic missiles developed by Iran, Syria and Hezbollah, a political and military organisation in Lebanon, could hit sites in Israel, including air bases and missile launchers.

The submarines of Flotilla 7 — Dolphin, Tekuma and Leviathan — have visited the Gulf before. But the decision has now been taken to ensure a permanent presence of at least one of the vessels.

The flotilla’s commander, identified only as “Colonel O”, told an Israeli newspaper: “We are an underwater assault force. We’re operating deep and far, very far, from our borders.”

Each of the submarines has a crew of 35 to 50, commanded by a colonel capable of launching a nuclear cruise missile.

The vessels can remain at sea for about 50 days and stay submerged up to 1,150ft below the surface for at least a week. Some of the cruise missiles are equipped with the most advanced nuclear warheads in the Israeli arsenal.

The deployment is designed to act as a deterrent, gather intelligence and potentially to land Mossad agents. “We’re a solid base for collecting sensitive information, as we can stay for a long time in one place,” said a flotilla officer.

The submarines could be used if Iran continues its programme to produce a nuclear bomb. “The 1,500km range of the submarines’ cruise missiles can reach any target in Iran,” said a navy officer.

Apparently responding to the Israeli activity, an Iranian admiral said: “Anyone who wishes to do an evil act in the Persian Gulf will receive a forceful response from us.”

Smart move by Israel, good move for the region, and a harbinger of the balancing to come.

Scary period to navigate, but much better chances for regional peace lie on the other side.